Government heading for political blow from debt downgrade

LONDON (Reuters) - Britain is lurching closer to an embarrassing loss of its prized triple-A credit rating as the economic outlook darkens, and the political pain for Prime Minister David Cameron’s government from a once-unthinkable move may exceed the economic damage.

Chancellor George Osborne speaks at the Global Investment Conference 2012 in London July 26, 2012. REUTERS/Neil Hall

Chancellor George Osborne warned of weaker growth and more austerity in a budget update on Wednesday. Although he avoided the political mis-steps for which the media lambasted him after March’s budget, there now looms the more menacing spectre of a downgrade before an election due in 2015.

Ratings agency Fitch said his admission that he will miss a key debt-cutting goal weakened his fiscal credibility. That fuelled fears Britain may be stripped of a top credit rating that has arguably helped keep borrowing costs at record lows.

Losing that crown would be a blow to Osborne and Cameron, who have staked their reputations on rebuilding an economy that suffered its biggest shock since World War Two during the financial crisis.

Their Conservative Party was forced to share power with Liberal Democrat rivals after the election in 2010, and the party’s leaders had hoped to win a full mandate from voters by proving their economic credentials.

They have repeatedly held up the triple-A rating as a vindication of their flagship policy to cut the deficit and retain the markets’ confidence.

“It is a political virility symbol,” said Jonathan Tonge, professor of politics at the University of Liverpool in northwest England. “It is hard to overstate the political significance if Osborne loses the triple-A rating.

“Osborne has invested so much political capital in this triple-A rating. In economic terms, losing it would not be catastrophic, it would be slightly more expensive to borrow. But it’s the politics of it that count.”

Britain has hung on to its top rating since 1978, towards the end of a decade which saw its economy blighted by the oil crisis, industrial upheaval and double-digit inflation.

While a downgrade would be politically damaging, analysts said the economic impact may not be as great as once feared.

“There are so few countries left now with a AAA rating, that to lose it would not be the stigma or threat to market confidence that it would have been a couple of years ago,” said Howard Archer, economist at IHS Global Insight.

“While this would likely be seen as an embarrassment for the government... this would actually have little negative impact for the economy.”

Standard & Poor’s removed its top rating from the United States in August 2011. France, Japan and China are other countries that do not have triple-A status with the agency.

Yet borrowing costs in many of those countries remain rooted near all-time low levels, as investors steer clear of trouble in indebted Southern European states and riskier emerging markets.

DEBT PRESSURE

Despite a bleak outlook, analysts said Britain was in better shape than some other major economies.

“The UK has neither the political risk facing the United States nor the structural rigidities and external debt pressures facing France,” said Lena Komileva, economist at G+ Economics, adding that many countries which formerly had AAA ratings were now rated a shade lower at AA.

Analysts at Lloyds welcomed Osborne’s decision to limit further austerity measures and said the muted reaction to his budget update in the financial markets suggested he had handled a difficult balancing act well and could even avoid a downgrade.

Resisting renewed calls to change course, Osborne said on Thursday that markets were less worried about a UK downgrade than Britain borrowing more and failing to tackle a deficit left by the last Labour government.

“My critics are saying Britain has got a debt problem, let’s add to the debt,” Osborne told the BBC. “It doesn’t make sense and it is exactly the kind of something-for-nothing economics that got us into this mess in the first place.”

Osborne appears to have escaped the public roasting that followed his March budget, which started a slump in his party’s fortunes that it has struggled to turn around.

The Financial Times said Osborne was walking a tightrope on the public finances, but “could have been more radical” with bolder growth measures.

However, the Independent was more critical, devoting its entire front page to a cartoon showing a malevolent Osborne dressed as a magician, pulling a rabbit’s skeleton out of a hat, with the headline “Osborne runs out of tricks”.

Others were also less sanguine about the economic effect of a downgrade, warning that sentiment towards Britain was fragile and could swiftly deteriorate.

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“The triple-A rating is everything. It is what has supported sterling from selling off over the last few years and if that were to go you would see gilt yields rising and sterling dropping like a stone,” said Christian Lawrence, currency strategist at Rabobank.

But it remains likely that it will be the political fallout that has the longer lasting effect, with the opposition Labour Party - which leads Cameron’s Conservatives by around 10 points in the polls - ready to seize on a move by the ratings agencies if it were to occur.

“George Osborne is a Chancellor in the last chance saloon, Labour finance spokesman told BBC radio on Thursday. “His judgements have been so woeful and so wrong.”

Additional reporting by Tim Castle and David Milliken; Editing by Toby Chopra